You incur an early withdrawal penalty on the IRA when you withdraw funds from your IRA before reaching the age of 59 and a half. The good news is that transferring an IRA from one account to another is not considered a distribution, so you can change financial institutions at any time without worrying about incurring a penalty. If you think you need the money and you are younger than 59 and a half, and the IRA is the only place you can get funds from, make sure you understand how the early withdrawal penalty works before you decide to withdraw part of your IRA.
How the Early Withdrawal Penalty Works for IRAs
Here’s an example illustrating how the early withdrawal penalty works. Suppose you’re 54 years old and you take $10,000 from your traditional IRA. The penalty will be calculated as follows:
The $10,000 will be considered income on your tax return. This income will be included with your other income sources to determine your total tax liability for the year. The amount of tax owed will depend on your tax rate, which is determined by your total income and deductions. In addition to the tax on the early withdrawal of $10,000, there will be an additional penalty of 10% on the withdrawal. In this scenario, that would be an additional $1,000 in taxes owed, plus increased regular income taxes due to the $10,000 increase in income.
If you haven’t paid enough during the year, you may owe tax at tax time, and you may also incur an additional penalty from the IRS for not paying your taxes in full. To avoid this, when you are distributing your IRA, it’s best to have taxes withheld directly from the distribution. So, if you are taking an early distribution of $10,000, and 30% is withheld for taxes, you will receive a check for $7,000, and $3,000 will be sent directly to the IRS for taxes.
Ask Your Financial Institution to Withhold Your Taxes
Your financial institution may be able to estimate the tax amount you will owe. If you’re concerned about the tax implications, ask your financial institution to withhold federal taxes, plus an additional 10% for the early withdrawal penalty.
Avoiding the Early Withdrawal Penalty
If you are using an early withdrawal from your IRA to pay off debts and avoid potential judgments, think again. Retirement accounts may provide some forms of creditor protection. Many of the creditor protection rules that apply to 401(k) accounts also apply to IRAs.
It’s hard to save enough to rebuild your account after an early withdrawal. You should consider your IRA funds like an egg in a basket. Do everything you can to avoid early withdrawal. If you must take funds from your IRA, check if you qualify for an exception to the early withdrawal penalty.
The above early withdrawal penalty also applies to early distributions from 401(k) accounts. Once you reach age 59 and a half (or age 55 in some cases for 401(k) plans), the penalty no longer applies to distributions. At that time, any withdrawal is considered normal income taxable to you.
Opportunity Cost
The penalty and taxes may not seem like much at first, but remember, that same $11,000 today will be worth $26,000 in 15 years if your investments earn a 6% annual return. Ask yourself, is this the best option for me? Is the tax penalty worth it? What other decisions have I made this year that might affect my taxes? In most cases, it’s best to leave your IRA alone if possible.
Questions
Frequently Asked Questions (FAQs)
Are early withdrawals from an IRA allowed?
Yes. There is no penalty for early withdrawals from an IRA used to pay up to $10,000 to buy a home for the first time, cover qualified higher education expenses, cover medical expenses, or in cases of disability.
Does a Roth IRA have different early withdrawal rules?
Yes. You can withdraw money from a Roth IRA without penalty if your account has been open for at least five years.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and credibility of our content.
IRS. “What if I Withdraw Money from My IRA?”
IRS. “Topic No. 413: Rollovers from Retirement Plans.”
U.S. Department of Labor. “FAQs on Retirement Plans and ERISA,” page 13.
IRS. “Topic No. 558: Additional Tax on Early Distributions from Retirement Plans Other than IRAs.”
IRS. “Retirement Topics – Tax Penalties on Early Distributions.”
Charles Schwab. “Roth IRA Withdrawal Rules.”
Source: https://www.thebalancemoney.com/how-the-ira-early-distribution-penalty-works-2388708
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